US inflation hits 40 year high

The main US inflation data has just been released, showing an unexpected rise to 7.0% in the year to December 2021. This is the highest since the 7.1% figure reached in June 1982. Even the narrower PCE Deflator Index, closely watched by the Federal Reserve Bank, reached 5.7% in November, up a further 0.6% on October.

The proximate causes are supply shortages and especially the energy shortage. But underpinning this is the 27% rise in M2 in the year to last February and the 13% rise in the year to last November. Together with expansionary fiscal policy this is adding to the imbalance between demand and supply. Not factored into these inflation figures but likely to affect those for early 2022 is the impact on labour shortages of the Omicron variant.

The massive fiscal and monetary expansion in early 2020 was part of a deliberate attempt to prevent the pandemic induced downturn from turning into a prolonged depression. It worked just a bit too well and, even some of us who supported the initial expansion were worried more than a year ago about the failure to turn the tap off as the economy bounced back. The authorities and particularly the Keynesian economics establishment haven’t exactly covered themselves with glory, first refusing to accept that higher inflation would be likely, then making a series of dog ate my homework excuses for why it was only transitory. Now that it has proved not to be, the issue is how to deal with the problem.

Federal reserve chairman Jerome Powell, not an economist himself, gives the impression that he feels his experts have let him down and seems to be adopting a hawkish stance. The next test for this will be the 26 January Federal Open Market Committee where there is a good chance that a new higher target for the Federal Funds rate will be announced.

Looking further ahead, what has to be done to deal with the inflation? Because we are in uncharted territory few have much of a feeling for how much medicine has to be applied. My best guess, and I don’t pretend it’s anything more than a hunch based on looking at these issues for nearly 50 years, is that the rate rise that might be necessary to slow the economy down could be surprisingly small – perhaps less than 250 basis points. 

But the reason that I think this to be the case is because I suspect that asset markets are likely to face an overgeared reaction to such a rise. In Cebr’s Top Ten forecasts for 2022, I surmised that we could see a 15-25% fall in asset prices over the next 18 months, pulling growth down virtually to a standstill during 2023. That, and the associated sharp rise in unemployment, should be enough to bring inflation under control.

None of this is great news for President Biden or indeed the leaders in other Western economies facing essentially similar issues.